While Washington Fiddles the Economy Burns

While media focus has been almost entirely on the short-term debt ceiling foolishness in Washington, not much attention has been paid to the more serious worsening of the six-month recessionary trend in the economy.

Yet that information and how you handle it will almost surely have more influence on your well-being going forward than Washington’s short-term political game-playing.

As I’ve noted numerous times over the last six months, Wall Street economists and the Federal Reserve have been woefully behind the curve on what is going on with the economy and inflation, even as the reality has been clear enough to those on Main Street.

The latest evidence of that can be seen in the Commerce Department’s release Friday morning of the GDP growth report for the second quarter.

There’s no way to sugar coat it, although Wall Street will no doubt try.

The economy grew at a 3.1% rate in the December quarter, not robust but reasonably solid. The consensus forecast of economists and the Fed was that under the influence of QE2 stimulus, growth would improve to 3.5% in the March quarter and for the rest of the year, with the economy’s underpinnings improving so it could stand on its own when QE2 expired in June.

Instead, March quarter GDP growth declined to only 1.9%. Economists and the Fed were sure that was only temporary and left their forecasts for the June quarter and rest of the year at 3.2% growth. Continuing negative economic reports in May and June forced them to scramble to lower their June quarter growth forecasts dramatically, to 2.8%, 2.6%, 2.0%, and finally to 1.8%.

Not enough. They were still way behind the curve.

Friday’s report was that the economy grew only 1.3% in the 2nd quarter, worse than the 1.9% originally reported for the 1st quarter.

But there’s more. These numbers are subject to revision as later information comes in. And in Friday’s report GDP growth for the 1st quarter was revised down to, if you can believe it, only 0.4%.

That is bad enough. But what are the odds that the 1.3% just reported for the 2nd quarter will also have to be revised dramatically lower as later information comes in?

I would say quite high given the evidence.

For instance, consumer spending accounts for 75% of the economy, and tepid consumer spending was cited in Friday’s GDP report as one reason for the dismal growth in the first half.

Unfortunately, it was also reported Friday that the closely watched University of Michigan’s Consumer Sentiment Index plunged from 71.5 in June to only 63.7 in July, the first month of the third quarter. It’s the lowest level of the consumer sentiment index in more than two years. That does not bode well for consumer spending going forward.

Meanwhile, small businesses account for most of the jobs in the U.S., and the National Federation of Independent Businesses (NFIB) reported last week that its Small-Business Optimism Index dropped in June for the fourth straight month, and “is solidly in recession territory.” That does not bode well for an improvement in the jobs picture going forward.

Those aren’t the only recent troubling reports. The Fed’s own National Activity Index, released by the Chicago Fed on Monday, is an index compiled from 85 monthly economic reports. It remained negative in June for the 3rd straight month, and its 3-month moving average declined to minus 0.6, perilously close to the minus 0.7 level that has marked the beginning of the last 7 recessions since 1970.

I don’t like to be the bearer of bad news, but this looks like another of those times when facing reality and making preparations could be of utmost importance.

Everyone is looking for relief from the stalemate in Washington, and it will be a relief to get that additional worry behind us.

But the fact is that an agreement on raising the debt limit will not change what is happening in the economy.

In fact, no matter which way it is resolved, it will likely add to the economic weakness.

An agreement to raise the debt ceiling would likely include long-term government spending cuts, basically a withdrawal of the stimulus that a high level of government spending has been providing to the economy. And failure to raise the debt limit would create serious problems for the U.S. in global financial markets, and raise interest rates in the U.S., both of which would be serious additional negatives for the economy.

As far as markets are concerned, my technical indicators remain on the sell signal of May 8. I expect brief rally attempts will continue, as was seen a few weeks ago in relief that another bailout effort for Greece was produced. There will probably be similar brief relief when the stalemate in Washington is resolved. But if so, when focus then returns to the economy, the market correction is quite likely to resume, with profits most likely for some time yet from downside positions against the market, and select safe havens.